Managing Portfolio Risk In The Current Market

Portfolio risk management is often the most ignored aspect of professional investment. Most investors do not understand the concept of portfolio risk management leave alone the ability to manage portfolio risk. Yogesh Supekar aims to simplify the concept of portfolio risk management while also explaining how best one can manage portfolio risk in the current market environment

Often investors chase returns. And why not considering that the whole game is to maximise returns on one’s investment! A closer look at the way markets operate will reveal that the stock market game is not that straightforward and in reality it is much more complex that one can imagine. For stock market professionals, it is relatively easy to understand how the market operates. However, for majority of new investors and first-time investors the market can be a punishing ground since they enter into the fray with only half-baked knowledge. The concept of returns is easily understood by investors as it is intuitive and straightforward.

However, what investors practically struggle is to understand is the ‘risk’ component in equity portfolios. At times even seasoned investors do not pay attention to the risk component in equity investments. Faster and better investors understand that risk management in equity portfolio is as important as picking outperforming stocks and can lead to a better and durable experience while investing in equities. Says Aditya Sarda, who has been investing in the markets for over 15 years: “In my initial years I use to ignore the risk factor completely. I use to focus only on returns to take investment decisions.” 

“It’s like 10 per cent earned betting on TCS is far superior than let’s say 10 per cent earned from Suzlon or R Com. One may argue that after all it is the 10 per cent return that counts. But now I know it’s not the same. Risk is much lower while betting on a stock like TCS than when compared to a stock like R Com or Suzlon and the lowering risk of the overall portfolio is as important as generating higher returns. Also, what I have realised is this – it takes 11 per cent gain to recover 10 per cent loss. This is achievable assuming it is a quality stock. But when a stock falls 20 per cent, it takes 25 per cent for a stock to recover those losses. It becomes a little harder but still it is recoverable,” he adds. “But when any investment falls by 40 per cent it takes 67 per cent subsequent gain and that could be a big problem. Similarly, a 50 per cent drop in prices would need 100 per cent gain to recover the loss and it could be devastating for portfolio performance. A drop of 75 per cent in stock prices would mean a recovery of almost 300 per cent, which I have realised almost never happens in a majority of stocks. It is catastrophic to have such stocks in the portfolio. Hence, I have learned risk management is the key and that one must at any cost limit the draw-downs in the portfolio,” he concludes. 

Indeed, risk management is the key to portfolio management. Essentially, there are three key elements to portfolio risk management or measuring portfolio risk. Protecting market gains is crucial to portfolio management especially when the market is predicted to get more volatile and is trading close to its all-time high levels. For instance, the Sensex has recovered almost 55 per cent from its March low but the Indian market may import volatility from overseas’ markets in the wake of the forthcoming elections in the US. According to Apoorva Vora, Founder and CEO, Finolutions LLP, at times such as now it is best to consider global investing in various asset classes. “With the markets once again hovering around all-time high levels and having risen by a good 40 per cent over the past six months, investors ought to calibrate their portfolios to ensure adequate returns on the higher side while also protecting any major downside risk.”

“While the pandemic situation is still uncertain, the markets have already priced in what will work after the pandemic and what will not. The markets have realised what companies will benefit the most going forward. A clear divergence around the globe has been experienced in terms of valuations being given to companies that have benefitted the most from this crisis. However, we feel that the scope for further price discovery is much less,” he adds. While equity markets are extremely hot at the moment it is an opportune time to diversify across different sectors in the equity portfolio across asset classes such as metals, REITS, fixed income and across geographies such as developed and emerging markets. 

“Having a well-diversified portfolio has been and will continue to be the most important element for all kinds of investors. In the near time, the markets are expected to be extremely volatile in nature given the US elections. Investors should not be surprised if they see a 10-15 per cent move in the equity market in either direction because of this big American event. In such times, it is necessary for investors along with their financial advisors to focus on reducing the standard deviation in their overall portfolio to be able to ride the volatility without being severely impacted. Also, in such cases, cash management becomes a very important strategy to be considered,” Vora states.

While experts such Apoorva Vora advocate diversification in different asset classes and geographies as the prime factor to risk management, Rama Ratnam, Director and Head of Products at Centum International Services further emphasises on international investing as the best way to minimise risk via diversification across geographies. “Allocation of investments outside one’s home markets tends to diversify returns and has a positive impact on risk-adjusted returns. The rationale of diversification is understandable as domestic equities or assets tend to be more exposed to the narrower economic and market forces of their home markets, but the assets outside one’s home market tend to offer a wider array of economic and market opportunities,” he points out. 

Rama Ratnam
Director and Head of Products, Centum International Services 

“In today’s world, investors have significant opportunities to build and diversify their portfolios by investing outside their home market. For example, the LRS route for resident Indians offers a great opportunity to do so. Despite these opportunities, investors have maintained or limited themselves to their home country even though the country’s market capitalisation weight might be much smaller compared to global markets.

To set the context, Apple has a market capitalisation of USD 2 trillion at the time of writing this article compared to some major Indian indices which also have similar market capitalisation. India is among the top 10 stock exchanges based on market capitalisation as per some studies. Still, there is an opportunity to diversify your portfolio globally by taking exposure in developed economies; the same thing goes for developed market investors who should take exposure in emerging economies for better risk-adjusted returns and lower volatility at a portfolio level.

Indian investors who are new to global investments should move 10-15 per cent of their total liquid portfolio in international markets, mainly in the US through an ETF index. Some products offered in the developed markets to professional investors help to hedge the portfolio better and can also contribute to a higher risk-adjusted return.

While deciding on the appropriate allocation to international assets, home investors across the globe are also influenced by some considerations. Broadly, such considerations involve barriers to investment such as limitations on the repatriation of investment income, tax considerations and higher transaction and friction costs, as for instance, commissions and opportunity costs.

While barriers to cross-border investment have been falling, transaction and investment costs are also coming down globally but can still be slightly higher outside an investor’s home market. While market capitalisation weightage is a valuable starting point for international diversification, several other critical factors should also be examined when considering an appropriate allocation to international assets. Investors should also carefully weigh the trade-offs, such as volatility reduction, implementation cost, tax considerations, AML requirements and their own preferences. One important consideration while investing in global markets is foreign exchange gain and losses. If an investor does not want that volatility, it can also be hedged.” 

Understanding Portfolio Risk

While diversification is key to manage portfolio risk and diversification is best achieved by parking money in different asset classes and different geographies, do we understand what risk is in the portfolio context and how best we can manage it? To start with it is enough to understand that the more volatile a stock the riskier it is considered. Small-caps are considered riskier not because they generate negative returns but because they are usually more volatile than their large-cap counterparts.

Volatility can be measured in terms of standard deviation. Therefore, ICICI Bank will be considered more risky than HDFC Bank if the standard deviation of the stock prices of ICICI Bank is more than that of HDFC Bank. Standard deviation measures volatility. On a portfolio level the summation of standard deviation of all the holdings in the portfolio, after considering the weightages, will be the portfolio risk. Naturally, each portfolio constituent contributes to the portfolio risk in its own unique way. If we include stocks that are more volatile on a daily basis it adds more riskiness to the overall portfolio. It does not by any means suggest that by adding more risky stocks there is an increased probability of negative returns.

Else, life for investors would have been very easy – with the only task in hand being to choose the least volatile stocks and lie passive. Practically it is seen that volatile stocks do generate above average returns – again not all volatile stocks do that. That is exactly why the equity market is considered complex. We know that small-caps and mid-caps are more volatile when compared to large-caps in general. Again, it simply means that the small-caps and mid-caps are more volatile when compared to large-caps if we compare the stocks prices on a daily basis. Hence, by adding a greater number of small-caps and mid-caps in the portfolio we add to the volatility of the portfolio and hence make it more risky.

One measure that investors should seriously consider while choosing stocks in the portfolio is the draw-down tendency of the stock. Small-caps and mid-caps have a tendency to have steeper draw-downs than the large-caps in general. Let us, for example, consider the overall performance of the constituents of BSE 500, BSE 200 and BSE Small-Cap index in 2020. The table below explains the draw-down experienced by the constituents of these indices.

The above table reflects the number of stocks with draw-downs in 2020. For example, there were 36 stocks from the basket of BSE 200 that fell by more than 50 per cent in the recent market crash while only one stock fell by more than 70 per cent in 2020 from the lot of BSE 200 stocks. We can see that almost 112 stocks or 22 per cent of all the 500 stocks saw a draw-down of more than 50 per cent in 2020 while three stocks that were constituents of BSE 500 index saw a draw-down of more than 70 per cent. Relatively, the draw-down for the BSE Small-Cap index constituents was high with almost 213 stocks out of 670 stocks slipping by more than 50 per cent in 2020. That works out to be almost 32 per cent of 670 small-cap stocks. 

"Risk comes from not knowing what you are doing"

-Warren Buffet

Clearly there is higher draw-down risk when one chooses to opt for a skewed portfolio towards small-cap stocks. Choosing a highly volatile stock over a steady performer may add to the portfolio volatility. For example, if we consider two stocks such as HDFC Bank and IndusInd Bank within the same sector we can see how adding one stock over the other can add to the portfolio risk. If we compare HDFC Bank, which has been a relatively low volatility stock and a steady performer, with IndusInd Bank, which had been one of the top performing banks until 2018 and yet one of the riskiest private banks, we can appreciate the importance of steady performers in the portfolio.

* Drawdown explains how much an investment or trading account is down from the initial investment value. 

HDFC Bank during the period between January 2016 and December 2019 inched up by nearly 134 per cent while IndusInd Bank gained not more than 58 per cent during a similar period. IndusInd Bank has clearly shown higher draw-downs when compared to HDFC Bank. This is also an example of the fact that higher volatility in the stock does not always mean that the returns will be higher. Sound risk management should involve decision-making where deliberately the stocks that are more volatile and show tendencies with higher draw-downs should be avoided in the portfolio.

When only those stocks that are steady performers with minimal draw-downs are included in the portfolio, the riskiness of the portfolio can come down drastically, thus boosting the risk-adjusted returns of the portfolio. The issue with the draw-down stocks is that higher the draw-down, more difficult it gets for the stock to outperform and beat the benchmark indices. Hence, a sound risk management strategy should start with stock selection. The average draw-down for the BSE 500 stocks in the recent market crash was 36 per cent while that for the BSE Small-Cap index constituents was 41 per cent.

The year 2020 can be taken as an example of a Black Swan event due to the pandemic and the draw-down in 2020 can be benchmarked as one of the worst periods for investors if we consider the market crash which started in February running up to March 23 when the markets hit the bottom of this year. Before constructing a portfolio, an accurate assessment of the riskiness of the stocks is warranted. The beta values, standard deviation and variance figures are mere statistical measures that can guide investors in ascertaining the relative riskiness of the stocks.

The interpretation of these statistical measures is the key to portfolio construction. Such period as now when the Sensex is close to all-time highs coming back from a solid recovery and where the valuations look stretched and are faced with one of the biggest event in the world – the US elections – matter to global equities. It can be adventurous to hold on to the high-beta stocks that may have helped investors beat the markets so far in 2020. A tactical shift to low-beta stocks can help protect the gains recorded for the investors. 

Benefits of Risk Profiling

Most investors operate in the markets without having done their risk profiling. Risk profiling will help protect long-term investors from buying unwanted stocks in the portfolio. Basically, after consulting with a financial advisor any investor should categorise himself or herself into a high risk, moderate risk or a low risk investor. It is important to understand here that not all stocks are good for all investors and it is only after taking into consideration the risk profile and the long-term investment horizon that any stock should be selected by individual investors. Akme Star Housing Finance, for example, has almost doubled since August 2020 but the stock is just not right for an individual who has categorised himself as a low risk investors.

"All of life is the management of risk, not its elimination"

-Walter Wriston

Akme Star Housing Finance is one of those low-liquid scrips with huge price swings that can unnerve the risk-averse investor even though it sounds great to know that the stock has yielded excellent returns in such a short period. Risk profiling will guide investors to buying a proper category of stocks that matches with the temperament of the investors. For low risk investor it is advised that large-caps should constitute at least 90 per cent of the total portfolio while the remaining 10 per cent can belong to small-cap and mid-cap categories. For high risk investor the allocation can be higher for small-caps and mid-caps with the weightage going as high as 50 per cent.

In large-caps the allocation should still remain fairly high at close to 50 per cent. For moderate risk-taker the allocation can be 70 per cent large-caps and the remaining 30 per cent can belong to small-cap and mid-cap categories. It is seen that several retirees and new investors participating in the markets show penchant for illiquid stocks and for stocks with low prices, showing no regards to valuation and volatility. Valuation is important for stock selection and so is the riskiness of the stock.

Conclusion

It is clear that risk management is different from hedging and should not be confused with safety. One just has to learn to manage risk proactively and there are various ways to do it, including diversifying your portfolio adequately and parking money in different asset classes and geographies. The essence of risk management lies in focusing on those areas where an investor has some control over the outcome while at the same time minimising the areas where an investor will have absolutely no control over the outcome. An excellent example would be leveraged trading. Investors can avoid leveraged trading using derivatives where the investors have minimal control over the outcome and focus more on building a long-term durable diversified portfolio where the investor has relatively better control on the outcome.

Sound risk management practices should include risk profiling, portfolio diversification, hedging wherever required, adequate stop losses to protect from huge draw-downs, identifying key portfolio risk zones in the portfolio and minimising them, making tactical moves as per the market condition and staying alert to the possibility of an uncertain event. Beta management of the portfolio can prove to be extremely useful for long-term investors. With an uncertain event ahead of us and markets facing multiple strong resistance zones, low-beta stocks could be preferred in the portfolio. Such volatile times call for stocks in the defensive sector to be included in the portfolio.

Pharmaceuticals, FMCG and IT stocks can have better representation and allocation at times such as now as we face heightened volatility scenario. Coincidently, pharmaceutical and IT sectors are also the sectors that have shown better earning visibility this season and the momentum is already there in these two defensive sectors. Also, a shift can be made from high-beta stocks where the quarterly result is not expected to beat the street estimates to relatively low-beta stocks where the results are expected to be impressive. For example, Bajaj Finserv is a high-beta stock where the company is not expected to post robust results while Ultra Tech Cement is relatively less volatile and carries a little low-beta value when compared to Bajaj Finserv that is expected to declare positive results.

Investors can shift from high-beta stocks to low-beta stocks that are expected to declare positive growth on QoQ and or YoY basis. Markets will take cues from the earnings’ season along with what happens in the US’ elections. It is expected that cement companies will declare positive set of numbers this season. Investors will have to monitor the quality of earning closely as cherry-picking a consistent performer is one of the best ways to manage risk in the portfolio. While focusing on the numbers and statistic measures such as beta, variance and standard deviations it is important to realise that risk perception is rarely entirely rational. 

Investors have a tendency of using a mixture of cognitive skills (evidence, reasoning and logic) and emotional appraisals (intuition, imagination) while assessing risks. There is always a psychological risk one undertakes when one invests. After all investing is an area in which an investor gets paid for embracing a certain level of uncertainty and discomfort. It is inevitable to face losses in markets. Successful investors learn quickly how to react to losses (risks) while majority of the investors get it wrong. When stock prices fall there is an element of emotional risk or psychological risk that we all undertake. When the stocks markets are rallying a nd are at record highs, the financial risk is highest since the prices can fall from higher levels and emotional risk is at its lowest.

At this point greed influences us. When markets crash the financial risk is low while the emotional risk is very high. That’s when fear grips us. That is why it is always advised not to make emotional decisions while managing a portfolio. When markets crash or stocks prices fall, one must get greedy and not the other way round. Also, when stock prices are trending and close to record highs, one must be fearful or cautious. Successful investors are able to manage their emotional risks in such way that the portfolio returns are protected i.e. they do not allow fear and greed to make their investment decisions. When emotional risk increases it leads to stress, worry, anxiety and uncertainty. The emotional risk increases when the stock prices move in the opposite direction.

With rising emotional risks, portfolio decision-making goes awry. Thus, portfolio risk management is also about managing emotions and not allowing emotional risks to influence portfolio returns. In case you are a trader or an investor who losses sleep over new stock purchase or keeps regularly looking at stock prices (minute by minute), it is a sign that you have taken more risk than you can digest.

Risk-taking is an inevitable part of equity investment. As an equity investor one has to embrace the risks rather than be fearful about them. Managing risk is about having a strategy in place with a clear goal to maximise the risk-adjusted returns. The problem with most investors is that they aren’t eager to think about risks. It is therefore high time portfolio risk management takes the centre-stage. Everything else may fall in place once portfolio risk management is done properly.